Bankruptcy Protection for the Participant and Alternate Payee

All divorce lawyers know that the bankruptcy of one or both spouses is always a consideration in an divorce. A spouse should always know the possible ramifications of a bankruptcy by his or her former spouse, particularly those considerations affecting property distribution.

In general, ERISA-covered pensions protect both the participant and the alternate payee in the event of the bankruptcy of either. ERISA’s anti-assignment rule, which provides that a pension benefit cannot be assigned to someone other than the participant unless a QDRO has been prepared or "another exception to the anti-assignment rule exists," excludes assets in pension plan from a bankrupt’s estate. In Patterson v. Shumate, 112 S. 2242 (1992), the Supreme Court found that ERISA’s anti-assignment rule, together with ERISA § 206(d)(1) and the Bankruptcy Code Sub. Section 541(c)(2) prohibits the assignment of a pension in the event of bankruptcy.

However, assets can be attached in bankruptcy "if the debtor’s contributions to the qualified plan were not valid and hence not protected by ERISA." If the participant places funds in ERISA-covered plan to dodge creditors during a bankruptcy action because he or she knows the plan contains an anti-assignment provision, "even if the participant could obtain the funds from the plan at that time, the funds may be protected under certain circumstances and cannot be reached in bankruptcy."

A note of caution. A retirement benefit can be attached after it leaves the protection of a qualified plan. Because many divorces end in the bankruptcy of the participant, a participant should consider a QDRO to transfer retirement assets to the alternate payee, "instead of withdrawing funds or obtaining a plan loan from a qualified retirement plan such as a 401(k)."

The alternate payee’s interest in a qualified plan remains protected even if the participant declares bankruptcy and no QDRO was prepared because the Bankruptcy Code provides that alimony, spousal and child support are not dischargeable debts. However, if a bankruptcy is being considered, "it is advisable that retirement assets be left in the retirement plan’s trust, because they are protected from the participant’s and/or alternate payee’s creditors’ claims."

If a participant later attempts to invalidate a QDRO through a bankruptcy proceeding, the interest of the alternate payee may depend on whether the type of debt created by the QDRO is dischargeable in bankruptcy.

If the alternate payee declares bankruptcy and a QDRO has been prepared, the Shumate protection against creditors reaching plan assets also applies to him or her.

Overall, when bankruptcy is a possibility, the best approach is to design a QDRO that provides for payment at a later date to avoid any attachment by creditors.

Authored By: Theodore K. Long, Jr., President, Pension Appraisers Online, Inc.

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